BIZD - Better High Yield Buy: Ares Capital Or Capital Southwest?

Summary

• Both Ares Capital and Capital Southwest offer investors very high dividend yields.
• Ares Capital is investment grade with a stellar track record whereas Capital Southwest has greater exposure to loans and offers a higher dividend yield.
• We compare them side by side and share our take on which is the better buy today.

Both Ares Capital ( ARCC ) and Capital Southwest ( CSWC ) offer investors very high dividend yields. Ares Capital is investment grade with a stellar track record, whereas Capital Southwest has greater exposure to loans and offers a higher dividend yield.

In this article, we will compare them side by side and offer our take on which one is a better buy at the moment.

Ares Capital Vs. Capital Southwest - Balance Sheet

ARCC has investment grade credit ratings from both Moody's and S&P, whereas CSWC does not have a credit rating from either.

ARCC's leverage ratio as of its latest quarterly report is reasonable at 1.27x and its balance sheet has immense liquidity of $4.5 billion ~(21% of its enterprise value).

CSWC's debt-to-equity ratio as of its latest quarterly report is also quite reasonable - and lower than ARCC's - at 1.11x, and the company has sufficient liquidity of $170 million (~15% of its enterprise value).

Overall, we give the edge to ARCC here. While its leverage ratio is a bit higher than CSWC's, it has greater liquidity and it also has an investment grade credit rating which CSWC lacks. We believe this gives it superior access to capital, especially if economic conditions worsen.

Ares Capital Vs. Capital Southwest - Business Models

CSWC has much greater exposure to senior secured loans than ARCC does at 85.3% vs. 69.3%. It also has greater overall exposure to debt investments (89.7%) than ARCC does (83.8%) and more of its debt trades at floating interest rates (93.0%) compared to ARCC's (86.6%). As a result, CSWC is more conservatively positioned than ARCC is at the moment.

Both companies also adopt a relatively defensive posture in regards to their sector selection, though we favor ARCC's. ARCC has 23% exposure to software and 11% exposure to healthcare as its top two industries, whereas CSWC has 11% exposure to the more cyclical media, marketing, and entertainment sector and 10% exposure to healthcare as its top two industries.

It is also worth noting that CSWC had 0.9% of its investment portfolio in non-accrual on a fair value basis, whereas ARCC also had 0.9% of its investment portfolio in non-accrual on a fair value basis.

While CSWC places more emphasis on debt investments and floating interest rate investments than ARCC does, ARCC has greater exposure to more defensive industries than CSWC does.

Ares Capital Vs. Capital Southwest - Dividend Outlook

Both businesses are booming at the moment and experiencing strong earnings per share growth thanks in large part to rising interest rates, which in turn is driving dividend growth.

Wall Street analyst consensus estimates have ARCC generating a 3.7% dividend per share CAGR and a 5.7% earnings per share CAGR through 2024.

Meanwhile, analysts expect CSWC to cut its supplemental dividend per share from this year's highs moving forward, resulting in a 6.5% annualized decline in total dividend payouts, though the regular dividend should be fine through 2024. On the other hand, earnings per share are expected to enjoy a very rapid 13.1% CAGR through 2024.

Given these projections, the balance sheet and portfolio strength, and positive exposure to rising interest rates at both BDCs, both dividends appear to have attractive outlooks moving forward, barring a deep recession that would cause defaults to soar and interest rates to plummet. Both management teams have discussed this on recent earnings calls.

For example, ARCC's management recently said :

We elected to raise the regular quarterly dividend from $0.43 to $0.48 per share because the company is now experiencing a higher level of core earnings, primarily due to the substantial increase in base rates. This increase, the largest quarterly increase in our company's history, is our third increase this year and results in a regular dividend that is 17% higher than our regular quarterly dividend level at the end of 2021.

The higher base dividend that we are paying also reflects our positive outlook on our ability to generate this level of core earnings under a variety of interest rate and economic scenarios for the foreseeable future.

On its latest earnings call, CSWC's management announced :

our Board has declared a $0.02 per share increase in our regular dividend of $0.52 per share for the quarter ending December 31, 2022. This increase represents 4% growth over the $0.50 per share paid in the September quarter and 11% growth over the $0.47 per share paid a year ago in the December quarter. These increases on our regular dividend are a result of the increased fundamental earnings power of our portfolio given its growth and performance as well as improvements in our operating leverage.

In addition, given the Federal Reserve's aggressive interest rate increases and the resulting excess earnings being generated by our floating debt portfolio, our Board of Directors has also declared a supplemental dividend of $0.05 per share for the December quarter, bringing total dividends declared for the December quarter to $0.57 per share. While future dividend declarations are at the discretion of our Board of Directors, it is our intent and expectation that Capital Southwest will distribute supplemental dividends for the foreseeable future, while base rates remain materially above long-term historical averages.

While ARCC's expected dividend growth rate is much better than CSWC's, CSWC has a much better expected earnings per share growth rate.

Ares Capital Vs. Capital Southwest - Valuation

Based on the numbers below, CSWC offers investors a higher earnings and dividend yield while trading at a very slight premium to ARCC on a NAV basis:

Investor Takeaway

On paper, these two stocks look pretty competitively matched as each has its strengths and weaknesses. ARCC has the investment grade credit ratings, superior liquidity, greater exposure to more defensive sectors, and a slightly cheaper price relative to its NAV. It also has the backing of a world-class asset manager in Ares Management ( ARES ).

On the other hand, CSWC has a higher earnings and dividend yield, greater concentration in loan investments, and a lower leverage ratio.

At the end of the day, we think it is hard to go wrong with either given that they both have crushed the S&P 500 ( SPY ) over the long term:

For now, however, we prefer ARCC given that we believe maximizing liquidity and access to capital (via its investment grade credit rating) is the most important single factor in a BDC in the current economic environment. Furthermore, ARCC is slightly cheaper relative to NAV which we think is important as it provides us with greater downside protection. We rate both as Buys right now, but would wait for meaningful dips in both stocks before building a significant position in them. You can read our full ARCC investment thesis here and see our latest in-depth analysis of the BDC ( BIZD ) sector along with our top picks here .

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